Gold On The Flip Side

Analysis: Gold – on the flip side

By Javier Blas in London

Published: December 16 2009 02:00 | Last updated: December 16 2009 02:00

All things for all people, everywhere. Or so says the motto of Harrods, the London department store. Except in jewellery, "all things" until recently did not include gold. But the store, heartened by the current rally in the yellow metal, now sells bullion.

"Sales are ahead of our expectations," says Chris Hall, Harrods' head of gold, as he shows a collection that ranges from tiny wafers of 5g, costing about $200, to a central bank-style 400 troy ounce bar valued at $480,000 (€329,000, £296,000). "People are buying several at the same time," he says of a bar costing about $38,500. "Not one is coming back to sell."

Across the world, other retail investors - encouraged by a weak US dollar, the financial crisis and fears that central banks printing money will lead to a spike in inflation - have done the same, overwhelming mints and gold refineries.

Demand for 1oz American Eagles, the world's most popular bullion coin, has been so strong that the US Mint ran out last month after sales hit a 10-year peak. In the first 11 months of the year it sold about 1.19m oz of Eagles, up almost 75 per cent year-on-year. Dealers also report unprecedented demand for small gold bars, particularly in centres such as Zurich that handle rich investors.

Although gold coins and small bars account for a smallish portion of the precious metals market, analysts see them as a good indicator of investor appetite. Big investors such as pension funds and hedge funds - including legendary names such as Paul Tudor Jones of Tudor Investment and David Einhorn, founder of Greenlight Capital - have also been enthusiastic. Mr Jones, whose company manages more than $11bn in bonds, equities and commodities, told investors recently that it was time to buy the metal. "I have never been a gold bug," he wrote, but added: "It is just an asset that, like everything else in life, has its time and place. And now is that time."

John Paulson, another well-known hedge fund manager, has adopted a similar view, telling investors he was concerned about the dollar. "So I looked for another currency in which to denominate my assets. I feel that gold is the best currency."

The buying frenzy pushed gold this month to a nominal all-time high of $1,226.10 a troy ounce, up 40 per cent since the start of the year, before shedding about $100. "The level of interest in gold is now higher than at any time of my 25-year career in the precious metals market," says Jonathan Spall, a director at Barclays Capital in London and author of Investing in Gold: The essential safe haven investment for every portfolio .

So many constituencies are taking refuge in the classic commodity that its price surge is the symbol of the age: a store of anxiety as well as value. And it is not only gold. Silver, platinum and palladium have also seen strong inflows. Sales of American Eagle silver coins, for example, have hit 26m oz, the highest in at least 23 years. Investment vehicles backed by physical deposits of platinum and palladium are swelling, bankers say.

To be sure, the latest gains look rather less impressive if adjusted for inflation. In real terms, bullion would need to be well above $2,000 an ounce to match the price achieved in 1980. But the rise over the last 10 years is almost 400 per cent - bringing concerns that the metal may have become subject to unsustainable speculative demand.

"Gold is in a bubble," maintains Tim Bond, head of asset allocation at Barclays Capital, who says investors should prepare for a correction. Nouriel Roubini, the New York University professor who was among the few to predict the financial crisis, holds a similar view, warning of "significant risks of downward correction". In a new report entitled, "The new bubble in the barbaric relic that is gold", he says: "The only scenario where gold should rapidly rise in value is one where fiat [official] currencies are rapidly debased via inflation." At the moment, however, there are "more deflationary than inflationary forces in the global economy".

How will gold buyers be able to tell when the top of the market is about to arrive? After all, gold is almost impossible to value beyond the cost of production, which today stands way below the current price. Apart from jewellery and small industrial applications, such as in electronics, gold has no use other than as an investment.

W arren Buffett, the legendary investor who has been a gold agnostic over the years, once said that bullion had "no utility". He added: "Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it." Mr Buffett's conclusion: "Anyone watching from Mars would be scratching their head."

Investors, bankers, analysts and traders have yet to agree on what is gold's fair value. Conventional methods applied to other commodities, such as crude oil or copper, to reach a valuation fail with gold. One critical piece of data needed to value commodities is inventories - and in the case of gold those are plentiful. The world's central banks keep in their vaults 29,700 tonnes of gold, enough to meet global demand - as measured by last year's consumption - for the next seven and a half years. Other analysts rely on arbitrary ratios between gold and oil or the S&P 500 index.

In the past, when gold backed the US dollar, the valuation that mattered was the ratio between bullion and the amount of fiat currency that the US government had printed. The US - the world's biggest holder - owns more than 8,130 tonnes of gold, while the Federal Reserve's monetary base is about $1,700bn. "So the price of gold at which the US dollar would be fully gold-backed is currently around $6,300 a troy ounce," says Dylan Grice, of Société Générale in London.

Another problem with gold is that, apart from its price appreciation, it yields no return. Bonds pay coupons; equities provide dividends. But in the current environment of extremely low interest rates, says Michael Jansen, European head of commodities research at JPMorgan, "the opportunity cost of holding gold is very low".

That could change as soon as central banks start raising rates, which will increase the attractiveness of bonds or even cash. "Gold, in normal interest rate circumstances, is a pretty expensive asset to hold," Mr Jansen adds. It costs money in vault fees and insurance premiums.

Losing out against yieldgenerating assets is one con cern now playing on inves tors' minds, bankers say. Then there is the worry about buying at the top of the market. Veteran gold investors remember how short-lived precious metals rallies can be. Take the last big gold spike in 1980. After a surge from $400 to $850 in just five weeks, bullion prices collapsed to trade as low as $300 a year later. Some investors were badly burnt.

The latest surge looks more robust, however: the price of the metal has hovered between $900 and $1,200 an ounce for the past two years. The rally has also been progressive, with prices gaining about $100 each year since 1999, rather than explosive in just a few weeks. Since the early 1980s, fundamental changes in the gold market have taken hold that suggest higher prices might last longer this time, even if they plateau.

On the supply side, two factors reinforce a bullish view. Mine output hit a peak around 2000 and since then has being on a downward trajectory, interrupted only by small blips. On top of that, production is moving from the easy areas - the big four being South Africa, the US, Canada and Australia - into terrain such as Ghana, Uzbekistan and Papua New Guinea.

Another source of supply - sales from central banks - has almost dried up. GFMS, the London-based precious metals consultancy, estimates that over the past 20 years net sales from the official sector, mostly from central banks in Europe, have run at an annual rate of about 400 tonnes - about 11 per cent of total supply. But sales in Europe have slowed to a crawl and Asian banks have started swapping their dollars for gold.

Kamal Naqvi, head of commodity investor sales at Credit Suisse in London, says the market has seen a "sea change" in central banks' attitude towards gold, "from a dead asset that should be sold because it does not yield, to a diversification tool".

The shift is important for the gold market on two fronts: the interest from central banks provides psychological support and, more important, caps a source of supply. When bullion prices hit a 23-year low of $250 an ounce in 1999 it followed large gold sales from the Bank of England and other European monetary authorities.

The demand side has also changed from the last big rally after the emergence of bullion-backed exchange traded funds (ETFs). As these vehicles trade in the same way as normal shares, each representing a fraction of gold held in a vault, investors have a trouble-free way to buy the metal.

The emergence of these vehicles, says Philip Klapwijk, head of GFMS, means that "institutional investors have been more important in this rally than in the early 1980s" when pension funds had difficulties investing in gold. In general, the cash poured into gold ETFs is seen as "sticky money" that should prove resilient in a bear market for gold.

The gold ETFs' growth has been explosive. Take SPDR Gold Shares, the largest in the sector. From almost nothing five years ago, it has ballooned to more than 1,100 tonnes of bullion - ranking above the holdings of central banks such as those of Japan or Switzerland.

The changes in supply and demand, many bankers say, mean that gold prices should remain high for the foreseeable future, although they are split on whether prices will surge further or have reached a plateau.

But there is a more important trend for the long-term future of the metal. For the first time in decades, investors are allocating a fraction of their portfolios to gold on a long-term basis.

That marks a return to normality, some argue. For centuries, gold has been central to savers. "The aberration had been the last 20-30 years in which gold moved out of most investors' portfolios," says Mr Spall.

Kangaroo

Australia

The Perth Mint, owned by the Gold Corporation of the government of Western Australia, has produced the Australian Nugget 'kangaroo' since 1987. The 24 carat coins are much in demand in the Asia-Pacific, with sales also strong in Europe

American Eagle

US

The world's most popular in spite of its relatively short history, as the US Mint did not start selling the 22 carat coin until 1986. By the Gold Bullion Coin Act of 1985, its gold has to be newly extracted from US mines

Maple Leaf

Canada

Introduced in 1979 by the Royal Canadian Mint as the first widely circulated gold coin to be produced in 24 carat bullion. Equivalent to 0.9999 millesimal fineness, it is the highest quality gold coin in circulation

Panda

China

First minted in 1982, the coins had a different reverse design each year until 2000 when the design was frozen. After investor requests, the mint reverted to the previous policy. On the obverse is the Temple of Heaven in Beijing

Vienna Philharmonic

Austria

The Austrian State Mint has produced the Philharmonic coin since 1989 in 24 carat gold. Five years ago it produced 15 giant versions, each weighing 1,000 oz. All were snapped up within days

Sovereign

UK

The Royal Mint has produced gold sovereigns for centuries but demand has quadrupled this year. The coin was first popularised by From Russia with Love , the film in which James Bond is given a briefcase holding 50 gold sovereigns

Krugerrand

South Africa

The Rand Refinery near Johannesburg has minted Krugerrands since July 1967 in 22 carat gold. It says it has sold about 46m troy ounces of gold in that form. Although of legal tender, it has no face value

Dress to invest

Jewellery has traditionally been the backbone of the gold market, thanks in particular to heavy demand from India, Turkey, China and the Middle East. But over the last year, purchases for investment have surged.

GFMS, a London consultancy, estimates that jewellery will account for 1,770 tonnes of gold used this year, down almost 20 per cent, with investment purchases up from 881 tonnes to 1,779 tonnes.